Brexit more important for interest rates than inflation

Brexit more important for interest rates than inflation

The Bank of England is hedging its bets about the direction of UK interest rates this year and Brexit will be the most important factor on the horizon, according to Ben Brettell, senior economist at Hargreaves Lansdown.

Mr Brettell said the Brexit outcome was more important than the inflation rate, which was released this morning (March 20) and had risen modestly to 1.9 per cent in February, up from the 1.8 per cent in January.

February marked the first month in which inflation has risen since the summer of 2018 but the rise was in line with expectation.

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In its report, the Office for National Statistics, which compiles the data, cited higher food and alcohol prices during the month as the reason inflation rose slightly.

Mr Brettell said the market had been "unmoved" by the news, as the outcome of the Brexit was more relevant. Sterling returned to the rate it was on Monday following the announcement.

He said: "The Bank of England has been setting a neutral tone as Brexit approaches, with policymakers hamstrung by political uncertainty and a deteriorating global growth outlook.

"The Bank has said it thinks higher interest rates will be appropriate in the coming months, as it aims to keep inflation close to its long-term 2 per cent target.

"News from the labour market yesterday suggests companies at least are carrying on regardless, hiring workers at the fastest pace for three years. A tight labour market would normally lead to calls for higher rates, but these are far from normal times.

"If Theresa May can somehow find a way to break the political deadlock in Westminster and Brexit happens in a relatively orderly fashion, we could see rates gently nudge up later this year.

"If we leave with no deal, however, all bets are off. I’d expect inflation to spike as sterling weakens, but the Bank has shown willingness in the past to look through this type of inflation and keep interest rates low to support the economy. I’d expect them to do the same here."

Inflation comes in two forms, demand side, and supply side. Demand side inflation happens when demand for goods and services in an economy rises and is generally positive for economic growth.  

Mr Brettell’s view is that if there is a Brexit with a deal, then demand side inflation would rise, and the Bank of England is likely to lift interest rates.  

Supply side inflation, is caused by an increase in the cost of getting goods to market. In a no-deal Brexit scenario, Mr Brettell expects the value of sterling to fall, and this increases the cost to producers of getting goods to market, as oil and other commodities are priced in dollars, so weaker sterling makes the cost of those inputs rise. 

Mr Brettell noted that when sterling fell in the immediate aftermath of the EU referendum in 2016, it was supply side factors which caused inflation to rise above the 2 per cent target, but the Bank of England ignored this because it viewed currency driven inflation as temporary.